China: TMT Liberalized In The Shanghai FTZ: Part 1

The China (Shanghai) Foreign Trade Zone (Shanghai FTZ) has new
opportunities for foreign investors wishing to invest in or expand
value-added telecommunication services (VATS) operations in China.
Foreign investors are now allowed to invest in the Shanghai FTZ to
engage in VATS operations that, outside the Shanghai FTZ, are
either not open to foreign investment or are subject to greater
restrictions on foreign ownership.

The Shanghai FTZ, formally launched in September 2013, is a
pilot ground for China's economic, financial and industrial
reform and innovation. Various rules have relaxed foreign
investment restrictions in certain business sectors, including
VATS, in the Shanghai FTZ.

Foreign Investment in VATS before the Shanghai
FTZ

Telecommunication services in China are divided into basic
telecommunication services and VATS. The Administrative
Regulations on the Foreign-invested Telecommunication
Enterprise, effective in 1 January 2002 and amended in 10
September 2008, (National Rules) allow foreign investment in both
basic telecommunication services and VATS. However,
publicly-available sources indicate that no foreign investor has
been approved to invest in basic telecommunication services under
the National Rules.1 As noted below, foreign investment
is allowed in VATS.

When it joined the WTO in 2001, China committed to open up three
of the eight VATS above to foreign investment.2
Specifically, China opened up item (1) online data processing and
online transaction processing business, item (5) store and
forwarding business, and item (7) information service business.

VATS is a highly-regulated sector for foreign investment. Under
the National Rules, foreign investors are not allowed to set up a
wholly foreign-owned enterprise (WFOE); rather, they must team up
with a Chinese partner to set up a joint venture (JV). Foreign
investment is capped at 50%.

To engage in VATS, a JV needs a VATS licence from the Ministry
of Industry and Information Technology (MIIT), which is the
authority in charge of VATS in China. The National Rules require,
among other things, that to engage in VATS in China (i) a JV must
have a total minimum capital contribution of no less than RMB 10
million (approximately US$ 1.6 million) for national or
cross-provincial VATS business, or a total minimum capital
contribution of no less than RMB 1 million for VATS business within
a particular province (approximately US$ 0.16 million), and (ii)
foreign investors must demonstrate to the MIIT their experience in
telecommunication industries overseas.

The National Rules allow foreign investors to set up JVs to
engage in limited VATS in China; however, it remains difficult to
obtain the required VATS licence. Based on the publicly-available
statistics, no more than 30 JVs have been granted a VATS licence to
date. China's reluctance to grant VATS licences to
foreign-invested entities may be a result of heightened internet
security concerns in the recent years.

New VATS opportunities in the Shanghai FTZ

On 6 January 2014, the Shanghai Municipal Government and the
MIIT issued the Opinions on Further Opening up Value-added
Telecommunication Business to Foreign Investments in the China
(Shanghai) Pilot Free Trade Zone (the
"Opinions"). On 15 April 2014,
the MIIT issued the Administrative Measures on Foreign
Investment in Value-added Telecommunication Business in the China
(Shanghai) Pilot Free Trade Zone (the
"Administrative Rules").

Both the Opinions and the Administrative Rules apply only to
entities that are established in the Shanghai FTZ to engage in
VATS. The Opinions introduce a number of new initiatives that allow
increased participation by foreign investors in VATS. The
Administrative Rules provide guidance on the application procedure
and documentation for VATS licences.

In Part 2 of our article we will outline some of the new
opportunities arising under the Opinions and the Administrative
Rules.

TMT liberalized in the Shanghai FTZ: Part 2

Part 1 examined the background of value-added telecommunication
services (VATS) in China and noted that new VATS opportunities have
opened in the Shanghai FTZ. These new opportunities have been
introduced by the Opinions on Further Opening up Value-added
Telecommunication Business to Foreign Investments in the China
(Shanghai) Pilot Free Trade Zone (the
"Opinions"), issued on 6
January 2014, and the Administrative Measures on Foreign
Investment in Value-added Telecommunication Business in the China
(Shanghai) Pilot Free Trade Zone (the
"Administrative Rules"), issued
on 15 April 2014.

Below are the salient points of the Opinions and the
Administrative Rules:

Greater foreign ownership permitted

Foreign Investors may own:

up to 100% in an entity engaging in an app store under
information service business,3 or a data store and
forwarding business; and

up to 55% in an entity engaging in operational e-commerce under
online data processing and online transactions processing
business.4

Three types of VATS had already been opened up to foreign
investment in China's WTO commitments; however, higher foreign
investment percentages are now allowed.

New VATS business available to foreign investors

Foreign Investors may own,

up to 100% in an entity operating a call centre business, or
engaging in a domestic multi-party communication business, or an
internet access business; and

up to 50% in an entity engaging in a domestic VPN
business.

Before the promulgation of the Opinions, these types of VATS
businesses were generally reserved exclusively for Chinese domestic
entities. Except those preferential treatments under CEPA as
mentioned in footnote 2, these opportunities are yet to be opened
up to foreign investors outside the Shanghai FTZ.

Expedited approval procedures on granting VATS
licenses

An entity wishing to engage in VATS is required to receive a
VATS licence from the MIIT. The timeline under the current National
Rules is approximately five months from acceptance of the
application.

For entities in the Shanghai FTZ, a VATS licence will be issued
by the Shanghai Communication Administration (SCA), which is the
local counterpart of the MIIT in Shanghai. Unlike under the current
National Rules, the SCA is not required to forward applications to
the MIIT in Beijing for approval. The SCA is required to issue the
decisions on approving the VATS license or not within sixty (60)
days after accepting the applications. Thus the Shanghai FTZ has
significantly reduced the approval time line for VATS licences.

Relaxed approval requirements on granting VATS
licences

The minimum registered capital has been reduced for a
foreign-invested VATS entity set up in the Shanghai FTZ. Outside
the Shanghai FTZ, a foreign-invested VATS must have a minimum
registered capital of RMB 10 million (approximately USD 1.6
million) to carry out cross-province VATS business. For
foreign-invested VATS entities set up in the Shanghai FTZ, a
minimum registered capital of RMB1 million (approximately
USD160,000) is required to apply for a VATS licence to carry out
cross-province VATS business.

Moreover, based on our telephone consultations with the SCA, it
is not necessary for foreign investors to provide operational
records in a telecommunication industry overseas, which is required
under the current national rules on the establishment of a
foreign-invested VATS entity outside the Shanghai FTZ. Therefore,
at least in theory, any foreign investor is allowed to set up an
entity in the Shanghai FTZ to engage in VATS.

Under the Opinions, each of the above VATS businesses can be
provided nation-wide by entities set up in the Shanghai FTZ,
provided that all related infrastructure and servers are located in
the Shanghai FTZ. The only exception is internet access services
which can only be provided to customers that are also located in
the Shanghai FTZ.

Implications for foreign-invested VATS business

VATS Licence

As noted above, it is difficult in practice for foreign-invested
entities to obtain a VATS licence. This, however, may be changing
for the Shanghai FTZ.

The Opinions expressly refer to VATS, and the subsequent
Administrative Rules set out the required documents and steps for
applying for a VATS licence. This indicates that the authorities
may be more willing to actually grant VATS licences to
foreign-invested entities in the Shanghai FTZ. The Chinese legal
community also generally expects that it should be relatively easy
in practice for an entity in the Shanghai FTZ to receive a VATS
licence from the SCA.

In light of the above, foreign investors may wish to re-evaluate
their existing business model, particularly if currently engaging
in VATS in China through a contractual cooperation arrangement with
Chinese partners (because of the difficulty in receiving a VATS
licence). Foreign investors planning to enter China for the first
time are also recommended to re-evaluate their plans for VATS in
China. For example, setting up a WFOE or JV in the Shanghai FTZ to
apply for the VATS licences and to engage in the VATS business
could greatly expand the available business opportunities.

Increased ownership permitted

Foreign investors in the Shanghai FTZ can now set up WFOEs or
majority-owned JVs to engage in certain VATS business, thus
avoiding possible corporate governance and operational conflicts
that can occur when teaming up with Chinese partners.

Abandoning the VIE structure

The requirements under the national rules, together with the
practical difficulty of obtaining VATS licences from the MIIT, have
deterred foreign investment in VATS. As an alternative, the
so-called Variable Interests Entities (VIE) structure5
has been extensively used by many foreign investors, and Chinese
internet entrepreneurs wishing to invest from overseas, to engage
in VATS in China.

Because of inherent regulatory and structural risks,6
VIE structures seeking overseas finance in the capital markets have
recently received increasing attention from foreign regulatory
authorities (especially in the US). The legality of the structure
has also been heatedly debated and challenged in the business and
legal communities. Foreign and Chinese investors looking for an
alternative to the VIE structure to engage in the VATS business in
China now have an alternative. Overseas capital markets and
regulatory authorities are also likely to welcome the abandoning of
the VIE structures.

Looking forward

The Shanghai FTZ provides foreign investors opportunities to
participate in and benefit from China's growing VATS
opportunities. The Opinions and the Administrative Measures also
signal a degree of VATS liberalisation and represent an important
development in Chinese telecommunication regulation. However, we
consider that China's telecommunication sector will continue to
be highly regulated, and will not be fully opened up to foreign
investments.7 Given the recent campaign by the Chinese
authorities to enforce internet security, any further opening of
VATS for foreign investment should not be expected soon.

Even though the SCA has started to accept applications for, and
issue VATS licences, it remains to be seen how the Opinions and
Administrative Measures will be implemented in practice. Specialist
advance legal advice remains necessary for investors exploring VATS
opportunities in China.

Footnotes

1 China Mobile, China Unicom and China Telecom, the three
biggest telecommunication operators in China, have their shares
listed in overseas stock exchanges; therefore, foreign investors
may invest in and own shares in these three Chinese basic
telecommunication service operators. However, the listings of these
three companies were specially approved by the Chinese government
and foreign ownership in them does not assist other foreign
investors who are interested in carrying out basic
telecommunication services in China.

2 Investors from Hong Kong and Macau are foreign investors.
However, certified services providers from Hong Kong or Macau are
treated separately under the Closer Economic Partnership
Arrangement and its subsequent amendments
("CEPA")
between Hong Kong and Mainland China, and between Macau and
Mainland China. Certified Hong Kong or Macau service providers are
allowed to engage in seven of the eight types of VATS (with the
exception being domestic multi-party communication services) in
China in the form of a JV. As a matter of practice, however,
relatively a few certified Hong Kong or Macau service providers
have ever received the VATS licences.

3 The operation of an app store is one of the many services
under information service business. The Opinions do not permit
higher foreign investment ownership in entities engaged in other
business (such as online data search or online visual or audio
service) that also come within the information service business
category; such foreign investments are still capped at
50%.

4 "Operationale-commerce"is one of the many services under
online data processing and online transactions processing business.
The Opinions do not permit higher foreign investment ownership in
entities engaged in other business (such as online stock trading or
electronic data interchange under online data processing and online
transactions processing business category); such foreign
investments are still capped at 50%.

5 In a typical VIE structure, a Chinese domestic operating
company holds a valid VATS licence in China, whereas a WFOE set up
by foreign investors (including Chinese entrepreneurs investing
through overseas entities) will enter into series of contracts and
documents with that Chinese domestic operating company or its
shareholders to control the corporate governance and operations of,
and to receive a majority of operations revenues from, the Chinese
domestic operating company.

6 The regulatory risk is that the activities of foreign
investors using a VIE structure to engage in the VATS business in
China may be considered as circumventing Chinese law with respect
to the restrictions on foreign investment in VATS business in
China. If it is considered as circumventing Chinese law, then the
VIE structure will be considered invalid in China. So far, this
risk of this happening is still heatedly debated in the legal
community, and markets have not reached a consensus. A structural
risk is that control by investors through series of contractual
obligations on a Chinese domestic operating company and its
shareholders is not as secure as control by investors directly
owning equity interest in the Chinese domestic operating company.
It is possible and, it has also occurred, that those contracts
under a VIE structure might be breached by the Chinese domestic
operating company or its shareholders. If breach takes place, then
investors (acting through WFOEs) could lose control of the domestic
operating company.

7 For example, one of eight types of VATS business, also an
important and inevitable business for cloud computing technology,
internet data centre business is still not available for foreign
investment, except it is available under CEPA as mentioned in
footnote 2.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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